Here's Why You Must Do Your Homework If You Want To Invest In Emerging Markets

People walk past a currency exchange office in Kiev October 16, 2013. It will be a jittery 18 months for Ukraine's international creditors, who are weighing up its $60 billion-plus debt repayment schedule against its fast-diminishing hard currency reserves. REUTERS/Gleb Garanich Increasingly vulnerable or fundamentally sound? Tactically bullish or tactically bearish? Views about emerging markets (EMs) had already been diverging before the Fed let the "tapering" genie out of the bottle in late May. With investor sentiment towards the asset class shifting almost from one week to the next, trading strategies for EMs are in a state of flux.

The two competing drivers of price action in EMs are the Fed and country-specific conditions. For the more vulnerable markets, the former is holding sway. Market perceptions of a slightly less dovish Fed after Wednesday's FOMC statement contributed to sharper falls in the prices of Turkish and Indonesian bonds than those of Polish and Malaysian ones.

Yet even in the riskier markets, it's not all about the Fed. Policy credibility and flexibility also matter. Take recession-plagued Ukraine whose credit rating was downgraded further into "junk" territory on Friday.

With "twin deficits" in the 6-7% of GDP range and a central bank burning through its rapidly dwindling FX reserves in a doomed attempt to defend the currency, Ukraine's woes make those of the so-called "fragile five" group of EMs appear relatively minor.

Differentiation within the EM asset class is becoming increasingly important. The Fed hasn't even begun "tapering" its asset purchases, and yet investors are already being forced to pay more attention to the idiosyncrasies of developing economies.

It's not just external funding positions that need to be scrutinised - other determinants of risk in EMs are coming to the fore. The politics of economic reform are extremely important in developing economies given the imperative of maintaining higher growth rates - particularly with the gap between EMs and advanced economies expected to narrow to just 3.3 percentage points this year, compared to nearly 6 in 2008, according to the IMF.